NEW VISION OF ENGINEERING ECONOMY COURSE (VISION) MODULE 3 LECTURE 3 Cairo, 14 July 2005

JULY 2005TEI OF PIRAEUS2 The Advanced Cost-Benefit Model Objectives: Theoretical model for investments evaluation Includes inflation rate in the cost Includes escalation rate in revenues More reliable than the simple cost-benefit model Decreases the uncertainty of the calculations

JULY 2005TEI OF PIRAEUS3 Model Parameters Parameters specified at the start point: Initial cost (IC o ) Maintenance cost (FC o =m IC o ) Variable cost (VC o =r IC o ) Revenues (R o =E c o ) Return of the investment index (i) Escalation rate of revenues (e) Inflation rate (g)

JULY 2005TEI OF PIRAEUS4 Initial Cost (IC o ) Basic equipment Additional installation equipment Installation cost Subsidy - loans

JULY 2005TEI OF PIRAEUS5 Maintenance & Operation Cost (FC o ) Depends on the elements of the installation (e.g. number of WTs) Maintenance cost Insurance cost Rents

JULY 2005TEI OF PIRAEUS6 Variable Cost (VC o ) Replacement of the basic equipment Frequency of the replacement Cost of the replaced equipment Serious damages during the operation

JULY 2005TEI OF PIRAEUS7 Annual Revenues (R o ) Production capacity Market price of the product Purchase agreement (e.g. guarantee power)

JULY 2005TEI OF PIRAEUS8 Return on the Investment (i) Depends on –local market investment opportunities –risk undertaken –personal goals of the investor

JULY 2005TEI OF PIRAEUS9 Escalation Rate of Revenues (e) Unforeseen economic situations (e.g. oil price) Inflation rate Historical data of the price

JULY 2005TEI OF PIRAEUS10 Inflation Rate (g) Reliability of the economy Economic and political perspectives Historical data

JULY 2005TEI OF PIRAEUS11 Annual Cash Flow YearCostRevenue 0C o =IC o, FC o =mIC o, VC o =r IC o R o =Ec o 1C 1 = IC o (1+i) + mIC o (1+g)R 1 = R o (1+e) 2C 2 = C 1 (1+i) + mIC o (1+g) 2 R 2 = R 1 (1+i) + R o (1+e) C 5 =C 4 (1+i)+mIC o (1+g) 5 +VC o (1+g) 5 R 5 = R 4 (1+i) + R o (1+e) n-1C n-1 =C n-2 (1+i)+mIC o (1+g) n-1 R n-1 = R n-2 (1+i) + R o (1+e) n- 1 nC n =C n-1 (1+i)+mIC o (1+g) n R n = R n-1 (1+i) + R o (1+e) n

JULY 2005TEI OF PIRAEUS12 Evaluation Criteria Pay Back Period Double Capital Period Economic efficiency

JULY 2005TEI OF PIRAEUS13 Pay Back Period G n = R n – C n = 0 ---> n * Investment is feasible if n* << n Investment is not feasible if n*=>n

JULY 2005TEI OF PIRAEUS14 Double Capital Period (DCP) Investment is attractive if n** < n Investment is not attractive if n**>n ---> n ** (DCP)

JULY 2005TEI OF PIRAEUS15 Economic Efficiency Investment is not feasible if η n * < 0 DCP after the lifetime of investment 0>η n *>100% Feasible and attractive investment η n * > 100% (Y n residual cost)

JULY 2005TEI OF PIRAEUS16 Example A private investor investigates the economic viability of a wind park of an initial cost of 1 million Euro. Assuming that the profit’s escalation rate is 5%, the inflation rate 4%, the expected annual income is 150,000 Euro and the investor expects a return index of the investment of 8%, what would you propose for the specific investment?